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Understanding the Effects of Nonliquidating Distributions on Corporations

By Albert B. Ellentuck, Esq.

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Nonliquidating corporate distributions are distributions of
cash and/or property by a continuing corporation to its
shareholders. At the shareholder level, a nonliquidating
corporate distribution can produce a variety of tax
consequences, including taxable dividend treatment, capital gain
or loss, or a reduction in stock basis.

At the corporate
level, a nonliquidating corporate distribution can also have
varying tax consequences. The distribution may have no tax
effect, or it may trigger corporate-level capital gain and/or
ordinary income. The corporate-level tax consequences of a
nonliquidating corporate distribution depend on whether the
distribution consists of cash or property (other than cash). The
corporation does not recognize gain or loss when it distributes
cash to shareholders or when it redeems stock in exchange for
cash payments (Sec. 311(a)).

Avoiding Corporate-Level
Gain

When a corporation makes a nonliquidating
distribution of corporate property other than cash (including a
distribution to redeem stock), the corporation recognizes gain
if the property’s fair market value (FMV) exceeds its adjusted
tax basis in the corporation’s hands (Sec. 311(b)(1)).
Specifically, the corporation recognizes gain as if it had sold
the appreciated property for FMV to the recipient shareholder.
When multiple properties are distributed, the corporation
computes gain on an asset-by-asset basis (Rev. Rul. 80-283). The
portion of the corporation’s gain attributable to recapture
items (e.g., depreciation recapture) is ordinary income, as is
gain attributable to the distribution of inventory and
unrealized receivables. Gain attributable to capital assets and
certain property used in a trade or business (Sec. 1231
property) is capital gain.

Practice tip: Corporations generally
report nonliquidating distributions to shareholders on Form
1099-DIV, Dividends and Distributions (Sec. 6042(c); Regs. Sec.
1.6042-4). The form breaks total distributions down into taxable
and nontaxable categories. Form 5452, Corporate Report of
Nondividend Distributions, is used to report nondividend
distributions to shareholders.

Example 1:A, B,
C, and D each own 2,500 shares of J
Corp., a C corporation real estate development
company. A disagrees with the other shareholders and wants the
corporation to redeem his stock for $60,000. A has
held his stock for three years, and his stock basis is
$59,000. A is not related to the other shareholders. The
corporation cannot afford to redeem the stock entirely for
cash because its cash balance of $75,000 must be used
primarily to service real estate debt. However, the
shareholders agree that J can distribute one of the
tracts of land to A (see the
exhibit). A does not care which tract of land he
receives in redemption of his stock because he plans to sell
the land immediately. The other shareholders feel that the
tracts will appreciate at about the same rate, so they are
willing to distribute any of the tracts. However, they want to
avoid corporatelevel gain.

If J distributes Tract 1 or Tract 2 to A to redeem
his stock, the corporation must recognize a $50,000 gain.
However, if the corporation distributes Tract 3, it will not
recognize any gain.

J could distribute $5,000 in cash and Tract 3 to redeem
A’s stock without recognizing any corporate-level gain.
This strategy would provide A with the $60,000 he wants
in exchange for his stock ($5,000 cash + $55,000 net equity in
Tract 3). Since all of A’s shares would be redeemed,
and because he is unrelated to the remaining shareholders, the
redemption would qualify for stock sale (capital gain) treatment
as a complete termination of a shareholder’s interest under Sec.
302(b)(3).

A’s basis in the stock is $59,000, so he would
recognize a $1,000 long-term capital gain from the redemption.
His basis in the land would equal its FMV on the date of
distribution, or $600,000. A’s holding period would
also begin on that date.

Recognizing Corporate-Level
Loss

Unfortunately, a corporation cannot recognize a tax
loss on a nonliquidating distribution of depreciated property
(i.e., where the property’s FMV is less than the adjusted
basis). A corporation is generally allowed to recognize tax
losses when depreciated property is distributed to shareholders
in complete liquidation of the corporation (Sec. 311(a)).

Example 2: Assume that H,
Inc., is a C corporation that is equally owned by E,
F, and G, who are not related in any way.
F and G actively manage H. Because
of disputes regarding F’s and G’s salaries,
E wants the corporation to redeem her stock (which
has a basis of $150,000). E does not care what assets
she receives as long as they have a total value of
$195,000.

H does not have enough cash to redeem the stock.
However, the shareholders have agreed to distribute a parcel
of land held for investment purposes and stock in a publicly
traded company, I, Inc., to redeem E’s
shares. The land has an FMV of $175,000 and basis of $150,000,
while the stock has an FMV of $20,000 and basis of
$40,000.

H cannot deduct a loss on a nonliquidating distribution
of depreciated property. Conversely, if it distributes
appreciated property it must recognize gain as if it had sold
the property to the shareholder for its FMV. Since the
corporation must compute its gains and losses on an
asset-by-asset basis, H would have a recognized gain of
$25,000 from the land and an unrecognized loss of $20,000 from
the I stock, if those assets were transferred to redeem
E’s shares.

Instead of distributing the
I stock, the corporation should sell it and distribute
the resulting sales proceeds to E. This would allow
H to recognize a $20,000 tax loss that would mostly
offset the $25,000 taxable gain from distributing the
appreciated land. Structuring the redemption in this fashion
would not cause any adverse tax effects for E. She
would recognize a gain of $45,000 ($195,000 FMV of assets
distributed to her less $150,000 basis in her redeemed shares)
regardless of which corporate assets she receives.

EditorNotes

Albert B. Ellentuck is of counsel with
King & Nordlinger, L.L.P., in Arlington, VA.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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